Bitcoin Price-To-Difficulty Ratio Spells Correction Ahead

Bitcoin prices have outpaced mining difficulty considerably, leading to boom times for Bitcoin miners, with monthly mining net profits on hardware investment now in the 15-23% range, implying breakevens from 4-6 months. But this party is likely soon to be over for the miners and probably also the Bitcoin price rise in the short term.

Last week, we examined the Bitcoin price in relation to its trend. This week we examine a "fundamental" indicator which is the Bitcoin price relative to the Bitcoin networks’ mining difficulty. Now bear with me and take the time to read the next two paragraphs for some background. It will be worth it, I promise, and is fundamental to your understanding of the Bitcoin ecosystem for future articles.

If you’ve ever wondered where Bitcoin comes from and how it goes into circulation, the answer is that it gets "mined" into existence. Bitcoin mining serves to both add transactions to the block chain and to release newly minted Bitcoin. The mining process involves compiling recent transactions into blocks and trying to solve a computationally difficult puzzle. The first participant who solves the puzzle gets to place the next block on the block chain and claim the rewards. The rewards incentivise mining and include both the transaction fees (paid to the miner in the form of Bitcoin) as well as the newly released Bitcoin (called the block reward). Currently a miner receives 12.5BTC block reward or around $21,000. Including transaction fees received by the miners, there is over $4M per day in mining income generated on the Bitcoin network. (Read more about Bitcoin mining here.)

The Bitcoin network difficulty is a relative measure of how difficult it is for Bitcoin miners to find a new block. The difficulty is adjusted periodically as a function of how much hashing (mining) power has been deployed by the network of miners. The higher Bitcoin prices get, the more attractive it is to mine for Bitcoins, and the more mining power is deployed onto the network. This raises the hashing power of the network which means more miners are competing to solve for blocks and the effort to find blocks becomes more difficult and mining becomes less profitable. As blocks are released constantly at a rate of about one every 10 minutes, it stands to reason that Bitcoin prices must rise to combat the inflation of difficulty. Similarly, if difficulty falls (rare but it does on occasion) then the Bitcoin prices should fall. If difficulty rises too much and/or the Bitcoin price falls too much then certain older (slower) mining hardware becomes loss-making due to electricity costs and they are taken out of commission, which in turn lowers the hash rate and makes mining more profitable for the remaining miners again. This self-regulating "circle of life" between hashing power, difficulty and Bitcoin prices makes difficulty an excellent mechanism to measure Bitcoin prices being oversold or overbought.

Bitcoin difficulty has risen about 11% per month compound, whilst Bitcoin prices themselves have risen 9% per month compound. So, in effect, the mining of bitcoins experiences diminishing returns of about 2% per month. This is why most mining profitability calculators allow you to add a difficulty rate increase which is defaulted to 2%. But things do not steadily increase at a compounded monthly rate, and for quite long stretches of time the price appreciation of Bitcoin outpaces the difficulty (leading to a boom for miners) and conversely the difficulty growth outpaces the Bitcoin prices growth (leading to diminishing returns for miners). This is shown below with a green line that is difficulty (the stepped black line) divided by the Bitcoin price (the blue line). If this line is rising, it means difficulty is increasing at a faster pace than Bitcoin prices and miners are experiencing diminishing rates of returns. If the green line is falling, it means the Bitcoin price is outpacing the difficulty and miners are experiencing abnormally high profit increases.

You can see that since around mid-March 2016, rapid rises in Bitcoin prices have been outpacing mining difficulty, leading to a steep fall in the green line which has been a bonanza for the Bitcoin miners. If you bought a Bitcoin miner or cloud mining contract today, then at current Bitcoin prices and difficulty your monthly net returns on initial Bitcoin investment are 15%-23% depending on which gear/mining contract you deploy.

But eventually this price rise is so great that the attraction of participating in the mining process becomes irresistible, resulting in more people participating in mining, which in turn leads to a jump in mining difficulty. So, the green line has limits to its "elasticity" (how far it can stretch) up or down, and we can measure this by calculating the distance from the green line to its regression mean (the slanted left-to-right straight black line). The chart below shows that the green line is now two standard deviations away from its mean. It is very stretched, like a rubber band reaching its limits, and ready to snap back. In fact, 3 of the last 4 major tops in the Bitcoin price occurred when the green line was more than two standard deviations from its mean.

This implies there is an abnormally high risk of a 15-25% correction in Bitcoin prices. Bitcoin prices have gotten too far ahead of network difficulty, and the forces of greed will result in heaps of mining power being thrown at the network to equalise things. So, whilst mining for Bitcoins is very attractive now, it’s going to rapidly become less attractive over ensuing weeks and months. It also just so happens that there is a limit to how far Bitcoin prices can outstrip network difficulty, and this massive increase in difficulty/hash power should predicate a correction in Bitcoin prices. When the pendulum has swung all the way to the other side at about plus one standard deviation, then this usually serves as a good re-entry point for those trading the coin.

Our long term forecast for Bitcoin remains bullish though, with an end of year target of $2,600 to $4,350, assuming current adoptions rates and no regulatory or technical hiccups. Be warned however that the path of Bitcoin to the objectives will be nowhere near as smooth as the forecasts imply. Any price below $1,400 should be considered a very strong buy.

Dwaine van Vuuren is a full-time trader, global investor and stock-market researcher. His passion for numbers and keen research & analytic ability has helped grow RecessionALERT.com (US based) and PowerStocks Research into companies used by hundreds of hedge funds, brokerage firms, financial advisers and private investors around the world. An enthusiastic educator, he will have you trading and investing with confidence & discipline.

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